Tax Consequences of Defaulted Loans

Despite reports that the economy is rebounding, real-estate values continue to remain depressed, and lenders and borrowers are confronted with ongoing loan workout and foreclosure issues in both residential and commercial markets. When a lender acquires collateral through foreclosure or deed-in- lieu of foreclosure, the value of the collateral often is less than the outstanding balance on the defaulted loan. Consequently, except in limited cases that involve nonrecourse financing, lenders must determine whether to discharge or collect an existing loan deficiency. This is often the primary focus of negotiations between a lender and borrower who are working through a deed-in-lieu of foreclosure transaction or an agreement that concerns a deficiency after a foreclosure.

In those cases in which a borrower's liability to repay a deficiency is discharged in whole or in part, federal income tax laws treat the borrower and lender as engaging in two separate transactions. First, the borrower is treated as selling the collateral to the lender for its fair market value, whether the "sale" occurs as a result of a foreclosure or a deed-in-lieu of foreclosure. In the case of nonrecourse loans, for federal income tax purposes, the lender is deemed to acquire the property from the borrower for the full amount of the debt, because there is no deficiency to collect.

The second part of the transaction entails reporting the deficiency. If the borrower repays the full deficiency, no additional reporting by the lender is required. In those cases in which the lender agrees to discharge some or all of the deficiency balance under the loan, unless the borrower is insolvent, the borrower is obligated to report the cancelled or forgiven debt as income on the borrower's federal tax returns.

In order to assure that borrowers are accounting for this sale and discharge of indebtedness income on their income tax returns, lenders are required to issue Forms 1099-A (Acquisition or Abandonment of Secured Property) and/or 1099-C (Cancellation of Debt) to the borrower and to the Internal Revenue Service (IRS). In those cases where the foreclosure or deed-in-lieu of foreclosure and the discharge of the deficiency occur in the same year, both transactions should be reported on one Form 1099-C. In those cases in which a foreclosure or deed-in-lieu of foreclosure and the discharge of the deficiency occur in separate years, lenders should (1) issue Form 1099-A, reporting the "sale" of the property by the borrower in the year of the property transfer, and (2) issue a separate Form 1099- C, reporting the discharge of indebtedness income in the subsequent year of the discharge.

There may be some confusion as to how lenders should calculate the forgiven amount of the deficiency to be reported on Form 1099-C. Given a borrower's potential tax liability, in many cases a borrower may object to the lender's reporting of the amount of the deficiency that had been forgiven by the lender. A partial discharge of a deficiency is usually easy enough to report, because the amount of the discharge typically is equal to the dollar amount of the deficiency forgiven. In those cases in which the lender has agreed to forgive the full amount of a loan deficiency, the loan deficiency (thus the amount reported on Form 1099-C) is equal to the excess of the outstanding principal, interest, fees, and costs that are due from the borrower over the fair-market value of the collateral property, on the date of the transfer of title to the lender (whether through foreclosure or deed-in-lieu of foreclosure). The fair-market value should be based on a recent appraisal.

In determining the amount of total indebtedness, lenders should be careful to exclude obligations that may arise only under a deed of trust (such as, the cost of a temporary receivership imposed on the property), if the borrower has no personal obligation to pay those amounts. Also, lenders should consider whether holding costs and costs of a future sale by the lender may be considered as reductions in the fair-market value of the property acquired by the lender, thereby increasing the deficiency. In some cases, particularly where the lender closes on a subsequent sale of the property shortly after a foreclosure or deed-in-lieu of foreclosure, a reduction of the property's fair-market value (and the commensurate increase in the deficiency) may be particularly appropriate. Lenders should be careful to issue a Form 1099-C only in the year that the deficiency is actually discharged.

As discussed, in some cases a Form 1099-A will be issued in the year of the foreclosure or deed-in-lieu of foreclosure; and a Form 1099-C will be issued in a later year, when the deficiency is forgiven. Except in bankruptcy cases, in which a deficiency often can be discharged without the lender's agreement, a Form 1099-C should be issued only once the deficiency has been discharged or once the lender's rights under applicable law to collect the deficiency have expired (as in the case of the expiration of a statute of limitations on collection).

A lender who issues a Form 1099-C, when the debt has not been forgiven, may create an argument for a borrower that the lender, in fact, forgave the deficiency. While Colorado courts have not ruled on this issue, the Arizona Court of Appeals recently ruled that a lender was not necessarily precluded from pursuing a deficiency simply because the lender had reported discharged debt on Form 1099-C. Receipt of a 1099- C from a lender "may be prima facie evidence of cancellation of a debt, [but] the lender may rebut that evidence by showing that when it issued the form it did not intend to forgive the obligation." (See AmTrust Bank v. Fosset, 223 Ariz. 438, 224 P.3d 935, 936-37 [Ariz. App. 2009].) Given the risk that an erroneous Form 1099-C can give rise to a presumption by a court that a loan has been discharged, lenders should take steps to assure that their staff do not treat a write down of a loan's value (or collateral), for banking regulatory purposes, as meaning that the deficiency should be reported as forgiven for tax purposes. To minimize claims from disgruntled borrowers, it may be wise for lenders to implement specific policies and procedures for issuing Forms 1099- A and 1099-C.

Other issues that may arise in connection with a lender's determination of a deficiency, and related discharge reporting requirements are beyond the scope of this article. Consequently, lenders are well-advised to seek legal and tax counsel to ensure that they are accurately calculating deficiencies and issuing 1099s as required, in order to avoid an IRS audit and/or penalties. Conversely, borrowers who are negotiating deeds-in- lieu of foreclosure, or who face potential tax liability for discharged debts, also should seek legal and tax counsel to protect their interests.